Monthly Archives: September 2008

Like the crisis itself, the conversation surrounding the Paulson Plan has devolved into clichéd talking points, ideological posturing, and an utter inability to discuss the situation in an intelligent and coherent fashion. Financial and political pundits are either heralding the defeat of the plan or lamenting its demise as the trigger towards another depression. Thus there is a great degree of uncertainty in the air as many are left wondering if the defeat of the Paulson Plan (or at least the 110-page House version of the plan) spells disaster. The short answer is “no.”

As I have previously mentioned, the problem in the financial markets is not a lack of liquidity, but rather the result of counter-party risk. The essential problem with the financial industry is the fact that firms need to raise capital, but are unable to do so because of the inability of other parties to accurately and adequately price the assets that the firms would like to sell. Accordingly, confidence must be restored in the market in order to get things moving again. The Paulson Plan, in its original form, would have allowed the government to purchase these assets at depressed prices thereby allowing for re-capitalization of the financials and allowing credit to flow. In addition, the stabilization of the housing and credit markets would allow firms and investors to more accurately price the assets in question. Thus, in theory, the government could buy low and sell high. However, the question remains as to whether or not the government can successfully execute this strategy. As our friend Thomas Palley explains:

The Paulson plan is subject to three fundamental criticisms. First, the Treasury may over-pay for assets, saddling taxpayers with large losses. If the Treasury sets its acceptable price too low, there is a risk it will buy insufficient assets and banks will not be cleansed. If it sets prices too high, the risk is Treasury overpays. Second, Treasury is taking a big risk as prices could fall further, yet it is not being properly rewarded for this risk-taking. That is tantamount to subsidizing banks which have created the mess. Third, markets may not provide finance even after Treasury’s purchases, in which case banks will remain undercapitalized.

The Paulson Plan therefore succumbs the knowledge problem. If those within the market are unable to accurately price these assets, it is unlikely that a government agency could succeed in doing so. In an ergodic world in which risk is easily calculable, the Paulson Plan would likely be successful. However, if the events of the last year have been any indication, the world is non-ergodic and the risks of default associated with mortgage-backed securities and collateralized debt obligations do not necessarily follow identifiable (or even existing) probability distributions (roughly, what Nassim Taleb refers to as the Fourth Quadrant). In the absence of easily quantifiable risk, the Treasury leaves itself prone to setting prices too low or too high and therefore resulting in either a failure to re-capitalize the financials or creating an exorbitant cost to taxpayers.

So while some are decrying the defeat of this bill as the beginning of something terrible, it seems prudent to at least take a step back and evaluate whether the plan could truly have been successful. I am not convinced.

Treasury Secretary Henry Paulson’s $700 billion proposal to stabilize the banking system may push the national debt to the highest level since 1954, threatening an erosion of foreign appetite for U.S. bonds.

The plan, which asks Congress for funds to buy devalued securities from financial institutions, would drive the debt above 70 percent of gross domestic product and the annual budget gap to an all-time high, possibly exceeding $1 trillion next year, economists estimated.

…many people are saying the government can only lose a portion of the $700 billion because there will be offsetting assets. This is true in the Fannie and Freddie conservatorship (the mortgage assets mostly offset the debt of Fannie and Freddie), but it is not true here. Although Paulson and Bernanke are talking about hold-to-maturity prices, they are also talking about both buying and selling securities. A little math will show that if you take a loss (say 30%) on each transaction, it doesn’t take many transaction to lose most of the entire $700 billion.

Keynes’s LPT can provide the explanation. LPT presumes that the economic future is
uncertain. Consequently, the classical ergodic axiom that is fundamental to any efficient market theory is not applicable to real world financial markets. Keynes’s analysis presumes that, in the real world of experience, the macroeconomic and financial systems are determined by a nonergodic stochastic system. In a nonergodic world, current or past probability distribution functions are not reliable guides to the probability of future outcomes [Davidson, 1982-3, 2007]. If future outcomes can not be reliably predicted on the basis of existing past and present data, then there is no actuarial basis for insurance companies to provide holders of these assets protection against unfavorable outcomes. Accordingly, it should not be surprising that insurance companies that have written policies to protect asset holders against possible unfavorable outcomes resulting from assets traded in these failing securitized markets find they have experienced billions of dollars more in losses than the companies had previously estimated. [Morgenson, 2008]. In a nonergodic world, it is impossible to actuarially estimate insurance payouts in the future.

Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

There is a better — and more transparent — way to put public capital into the banks while protecting taxpayers: through the Federal Deposit Insurance Corp. The FDIC has long had the power to handle failed banks. But in 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) that limited the FDIC’s ability to provide assistance to struggling but still solvent banks.

The exception is when there is a risk to the entire financial system. In that case, the President, Treasury Secretary and two-thirds of the Fed board can authorize such open-bank aid. The current moment would seem to qualify. Yet the White House has so far refused to trigger this exception and let the FDIC work with the likes of Wachovia, Morgan Stanley, and others before they crash and burn.

Whether or not the Paulson plan passes, President Bush should sign the FDICIA waiver. This would allow Treasury and the FDIC to inject new capital into banks early enough to prevent failures; in return, the feds could impose some discipline in the form of management dismissals and preferred stock or warrants that would protect taxpayers when the banks recover. This also beats the Congressional idea of attaching taxpayer warrants to the Paulson plan, which will be much harder to administer to hundreds of banks as opposed to one at a time through the FDIC.

I look at the situation as follows. Banks are bridges between savers and investors. Some of these bridges have collapsed. But altogether too much attention is being placed on fixing the collapsed bridges. Instead we should be thinking about how to route more savings across the bridges that have not collapsed. Government lending may be one way of doing this but why lend to prop up the broken bridges? Instead, why not lend directly to the investors who are in need of funds? After all, if these investors exist and have valuable projects that’s where the money is! Let the broken bridges collapse, taking the shoddy builders with them. Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.

Any solution should observe three guiding principles: It should (1) restore the stability of the financial system quickly and at the lowest possible cost to the taxpayer; (2) punish those who are responsible for losses; and (3) address the root cause of the crisis — the price collapse in the residential real-estate market. In doing so, the solution should respect the rule of law by spelling out the proposal in sufficient detail for the Congress and the electorate to pass judgment. To the extent possible, it should follow proven precedents.

(There has been a recent discussion regarding the Paulson Plan with a great number of individuals comparing it to the Resolution Trust Corporation (RTC) that was created after the savings and loan crisis. The purpose of this post is to explain the S&L crisis and then (very) briefly contrast the RTC with the Paulson Plan. The information on the S&L crisis comes from my lecture notes for Money and Banking. The main resource used in putting together these notes is Frederic Mishkin’s Economics of Money, Banking, and Financial Markets. Any errors are my own.)

Before the 1980s, federal deposit insurance seemed to work exceedingly well. Bank failures between the creation of the FDIC and 1980 were very rare. This changed greatly after 1981.

Early Stages

Financial innovations, as we have previously discussed, severely cut into the bottom line of the traditional banking business. Commercial banks were losing money to instruments like money market mutual funds.

As profitability fell, banks were forced to undertake new activities. These activities tended to be very risky, including the failure to diversify loans and purchase of financial futures and junk bonds. Further, the fact that the government stood to provide insurance in the wake of a failure provided little incentives for banks or their customers to fully take account of the risk involved in these new activities.

The following set the stage for the problem:

• Deregulation gave more power to S&Ls beyond home mortgages.

• This deregulation was coupled with an increase in the mandated amount of deposit insurance (from $40,000 to $100,000).

• Deregulation also phased out Regulation Q, which had placed ceilings on interest rates.

• S&Ls began engaging in new activities in which many managers were not qualified.

• There was rapid growth in new lending, especially in real estate.

• The quest for profitability began to cause banks to ”specialize” in loans to certain industries.

The consequences:

• Increases in inflation and contractionary monetary policy put upward pressure on interest rates leading to rising costs that were not matched by higher earnings because most mortgages were issued at lower, fixed rates.

• A recession in 1981-1982 caused a collapse in the prices of energy and farm products which led to significant defaults on loans among S&Ls.

• HUGE collapse of S&L industry with more than have with negative net worth (insolvency) by the end of 1982. Losses were estimated at about $10 billion.

Later Stages

Exacerbating the problem:

• Regulatory agencies lacked the funds to close the S&Ls and pay their depositors.

• Regulators used regulatory forbearance. In other words, they failed to exercise their regulatory powers.

• Savings and Loans began to take a great deal of risk to grow out of insolvency.

• The results were disastrous. Insolvent institutions were unknown to the general public and the insolvent firms were competing alongside the solvent. This forced solvent firms to pay higher rates of interest in trying to compete with the insolvent firms who were desperate for funds to make risky bets. This squeezed the lifeblood from the solvent banks and even dragged some of them into insolvency.

Competitive Equality in Banking Act of 1987

The CEBA gave financing to the regulatory agency of the S&Ls, but the funding was not sufficient and was even below the requested amount by President Reagan (which was also probably a low balled number to begin with – $15 billion). Further, regulatory forbearance continued at the behest of Congress. The losses continued throughout the 1980s.

Upon taking office in 1989, President George H.W. Bush proposed new legislation to provide the adequate funding to close the insolvent S&Ls. The FIRREA did the following:

• Eliminated the former regulatory structure that was in place and gave this power to the Office of Thrift Supervision.

• Further, the S&L insurance system was eliminated and the FDIC overtook these powers.

• Finally, the Resolution Trust Corporation (RTC) was created to sell off the real estate assets of the insolvent thrift firms. The RTC was able to sell 95% of the assets of the insolvent firms, with a recovery rate exceeding 85%. Afterwards, the RTC went out of business in 1995.

• The bailout cost $150 billion.

Federal Deposit Insurance Corporation Improvement Act of1991

The FDICIA followed from the FIRREA and was passed for two reasons:

• To recapitalize the FDIC’s Bank Insurance Fund.

• Reform deposit insurance and regulatory system to minimize taxpayer losses in the future. To minimize moral hazard, the FDIC must now close failed banks using the least costly method. This creates the likelihood that uninsured depositor losses will occur. A provision exists, however, in that if two-thirds of the Governors of the Federal Reserve and the directors of the FDIC deem an institution ”too big to fail” and is approved by the Treasury Secretary, all depositors will be protected. This should only be done when the failure to do so would result in significant economic losses.

In addition, the FDICIA created a ranking of banks by the level of capitalization. Banks in the lowest group are prevented from paying above average interest rates on deposits and can even be closed by the FDIC if the amount of equity capital falls below a certain percentage of assets (2%).

The Paulson Plan Versus the RTC

The preceding analysis hopefully provides enough background to discuss the Paulson Plan in contrast to the RTC. Under the Paulson Plan, the government would be purchasing assets with uncertain value from currently operating institutions. This is a direct contrast to the RTC in which the government was selling the assets of failed institutions. The Paulson Plan raises many important questions. Uncertainty is the primary reason that firms cannot estimate the value of their assets. Given this uncertainty, counter-parties are unwilling to purchase such assets because of the fear that they might overpay. How precisely will the government entity created under the Paulson Plan value these assets when those in the industry do not? Further, what incentive does the entity have to ensure that they are purchasing the assets at a favorable price?

The lack of oversight and incentives suggests that the Paulson Plan is one that is likely to overpay for assets that few, if any, are able to accurately price under current conditions. This represents a significant bailout for Wall Street at the expense of taxpayers, which is neither warranted nor acceptable. Whether or not any such bailout would put an end to the crisis is debatable. However, what is not debatable is the dangerous precedent that such action would set. I urge my fellow economists, and fellow taxpayers, to reject such a plan.

Gary Gorton has written a new NBER working paper entitled, “The Panic of 2007”, in which he describes the origins of the current financial crisis. Here is the abstract:

How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.

If you aren’t reading Larry White’s commentary on the crisis, you should be (see here, here, and here). Here are some of my favorite quotes:

“Uh-huh. Now explain to me how an “auction facility” works when there’s only one buyer.”

“On greed, let me repeat: If unusually many airplanes crash during a given week, do you blame gravity? No. Greed, like gravity, is a constant. It can’t explain why the number of crashes is higher than usual. And let me add: This isn’t a morality play. What we’re seeing are the consequences of monetary-policy distortions of interest rates and regulatory distortions of incentives, amplified in some degree by private imprudence, not the consequences of blackheartedness.”

“Proponents suggest that it would be (kinda, sorta) like the Resolution Trust Corporation that liquidated failed savings and loans after 1989. But the RTC only acquired assets from closed thrift institutions in liquidation. It did not subsidize ongoing institutions, and did not buy dubious assets. Once the assets were sold for whatever they would fetch, the RTC closed up shop. The newly proposed institution is a very different animal. It is hard to imagine how that institution — given its mission — could be designed so as not to subsidize Wall St. imprudence at taxpayer expense, and thereby foster rent-seeking and moral hazard on a colossal scale.”